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A pregnant bump in British inflation Samuel Brittan Financial Times 26/01/07 In every year since 1999 and in many since the mid-1990s, UK inflation has been notably less than that of the eurozone, the US and the average of the Group of Seven developed countries. That is until the middle of last year. Since then, the UK inflation rate, now 3 per cent, has crept up to about a percentage point above these groups. In itself that is not so tragic. But the trouble with a little bit of inflation is that, like a little bit of pregnancy, it grows. It is not a good sign that the balance of CBI employer group respondents expecting to increase prices is the highest for more than 11 years. I suspect that Michael Saunders of Citibank is right when he observes that headline inflation may fall this year, but the medium-term inflation threat may worsen. What has gone wrong? Mervyn King, Bank of England governor, this week mentioned the sharp rise in energy prices which has only partially been reversed. But this is not all. He mentioned three other factors: a rapid growth of money and credit contributed to rising asset prices and “buoyant nominal spending”. Second, and as a result, inflationary expectations by business have risen. Third, there have been rising cost pressures – some of them, I would add, specific to the UK. These include higher pensions costs and higher taxes. As the governor more or less said, demand pressures would have led to still higher inflation had it not been for the “safety valve” of immigration which has produced an inflow of willing workers happy to work at the going pay rates. Perhaps most worrying is that the increase in both relative and absolute inflation has occurred despite a rise in the sterling exchange rate which should have acted as a damper. This has implications for future monetary policy. Any future fall in sterling, which might otherwise have been regarded as a contribution to rebalancing the economy, will now have to be scrutinised, eagle-eyed, to ensure that it does not encourage an inflationary take-off. At present there is little the Bank can do other than monitor events and not be afraid to raise interest rates when and if necessary. The strong fourth quarter gross domestic product estimates and other bullish real economy indicators should weaken the obstructive power of the Bourbons on the monetary policy committee who are reluctant to take monetary aspects seriously. The governor has made a rod for his own back by not protesting more publicly against the change three years ago in the specific inflation index to be targeted. It took more than a decade to persuade people to look at an index that excluded mortgage interest payments – RPIX. This was not ideal, but at least brought to an end the self-defeating cycle by which interest rate increases, meant to subdue inflation, had as their initial impact a rise in headline inflation. But instead of leaving well alone, chancellor Gordon Brown announced three years ago a change to the European Union-style consumer price index which excludes all elements of housing costs. The decision might have owed more to Blair-Brown infighting over the EU than any reasoned analysis. The result has been mainly to undermine the credibility of official inflation figures and of official statistics in general. When the headline “All Items” retail prices index reached 4.4 per cent in December it might have been possible to persuade people to look at the 3.8 per cent registered by RPIX. But when they are asked to look at the still lower figure of 3 per cent on the new definition, it only increases suspicions. These are easily aroused when, many analysts have pointed out, the items which have remained stable or fallen in price represent discretionary and occasional purchases, while the more rapidly rising items such as food and fuel have constituted the essentials in most family budgets. It has probably been a mistake for the Bank to harp so much in its utterances on the tendency of wage settlements to follow the headline RPI, which could be a self-fulfilling fear. Unfortunately, the Office of National Statistics has added to the muddle by publishing many different so-called “inflation rates” for different items. This confuses inflation, which reflects the decline in the value of money in general, with relative price changes, which are a function of any normal economy. Policymakers will have to realise that it is unrealistic to define price stability in terms of yearly inflation targets. During the century of UK price stability before the first world war, the price level sometimes changed by up to 5 per cent in individual years; but the upward and downward movements roughly cancelled each other out. Thus the best assumption a Victorian family head could make was that a pound left to his grandchildren would be worth roughly the same as a pound in his own day. Any attempt to move to such a basis today would rightly be dismissed as just explaining away rising current inflation. But it would be worth bearing in mind, if and when inflationary fears have subsided, as a more realistic long-term goal.
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